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Thursday, December 30, 2010

I have been arguing here for sometime that the Great Recession of 2007-2009 was nothing more than a pronounced money demand shock that the Federal Reserve failed to fully offset. As a consequence, nominal spending collapsed and given sticky prices the real economy crashed too. This seems self evident to me and other so called quasi-monetarists (a term coined by Paul Krugman) like Scott Sumner, Bill Woolsey, Nick Rowe, and Josh Hendrickson. Some folks, however, do not buy it. They disagree that the fundamental problem was a money demand shock and by implication they disagree that the Fed could have done anything to offset it. This thinking can be vividly seen in the responses to my National Review article where I make the case for QE2 with a money demand shock story.

A more thoughtful response to my argument comes from Brad DeLong who says rather than a narrow money demand shock being the underlying cause of the Great Recession, it was a broader liquidity demand shock. Thus, the demand for all highly liquid assets increased and derailed nominal spending. Though some of the quasi-monetarists may disagree with him on the details, I think they would agree with DeLong in general and might even call him a closet quasi-monetarist.

So what is the evidence for DeLong's theory of a great liquidity demand shock? I went to the flow of funds data and looked up the share of highly liquid assets as a percent of total assets for the (1) household and nonprofit sector, (2) the nonfarm nonfinancial corporate business sector, and (3) the nonfarm noncorporate business sector. For highly liquid assets I sum up for each sector currency and checkable deposits, time saving deposits, money market funds, and treasury securities. Presumably, the share of highly liquid assets as a percent of all assets for each sector spiked during the crisis if in fact there was a great liquidity demand shock.

This figure shows that the share of total assets for households and nonprofits allocated to highly liquid assets was declining since the 1980s. This downward trend was dramatically reversed beginning around 2007 and is still elevated.

Next is the figure for the nonfarm nonfinancial corporate business sector:

Here too, there is aspike in the share of highly liquid assets. Though the share has gone done slightly, it is still elevated relative to the pre-crisis period.

My takeaway from these figures is that (1) there was a great liquidity demand shock and (2) the Fed failed to sufficiently offset it. Presumably, one objective of QE2 is to bring theses shares back into line with pre-crisis values. The figures indicate, though, there is a long way to go before that happens.Update: If the treasury securities are eliminated from the numerator in the above figures then one gets something that more closely measures the share of assets allocated to traditional money assets. The figures for the three sectors are here, here, and here. These figures are very similar to the ones above. Thus, money demand appears elevated too.

Monday, December 27, 2010

Paul Krugman explains the main reason for the rising commodity prices:

[T]oday, as in 2007-2008, the primary driving force behind rising commodity prices isn’t demand from the United States. It’s demand from China and other emerging economies. As more and more people in formerly poor nations are entering the global middle class, they’re beginning to drive cars and eat meat, placing growing pressure on world oil and food supplies.

There are many observers who disagree with this interpretation. They argue it is loose U.S. monetary policy and speculation that is driving the surge in commodity prices. Krugman notes there is a way to test this alternative theory:

The last time the prices of oil and other commodities were this high, two and a half years ago, many commentators dismissed the price spike as an aberration driven by speculators. And they claimed vindication when commodity prices plunged in the second half of 2008.

But that price collapse coincided with a severe global recession, which led to a sharp fall in demand for raw materials. The big test would come when the world economy recovered. Would raw materials once again become expensive?

If so, then Krugman's theory is more plausible. So what does the data show? Is there is a close relationship between the growth in emerging economies and commodity prices? Here is a figure that shows the year-on-year growth rates of industrial production in emerging economies and the CRB Commodity Spot Index: (Click on figure to enlarge.)

I'd say Krugman has a solid case. One could argue, though, that because the Fed's monetary policy gets exported to much of the emerging economy its monetary policy is providing stimulus to these countries and through them is indirectly putting upward pressure on commodity prices. Even so, this still does not mean U.S. monetary policy has been too loose. It could be that the Fed's global monetary stimulus is simply putting the emerging economies back on their trend growth path. After all, the emerging economies were growing in the double digits before the Great Recession and are only now returning to trend growth. This can be seen in the figure below: (Click on figure to enlarge.)

At a minimum, Krugman's argument should give pause to those observers who point to rising commodity prices as a harbinger of runaway inflation. There are many factors driving global commodity prices. U.S. monetary policy is only one of them and probably is not the most important.

P.S. See ScottSumner for more on what commodity prices tell us about monetary policy.

Update: Menzie Chinn looks at petroleum prices and comes to a similar conclusion. Here is an interesting excerpt from his post:

One last observation regarding the monetary/real debate over the oil price resurgence. If indeed oil prices were rising over the past month primarily because of monetary policies in the US, one would expect the oil price change in the US to diverge from that in other economies not undertaking another round of quantitative expansion. Figure 4 shows the price of oil expressed in dollars, and in euros.

For the jump in prices during December, I don't see a pronounced divergence.

Wednesday, December 22, 2010

This is the famous equation of exchange where M is the money supply, V is velocity, P is the price level, and Y is real GDP. Back in 2009 he questioned Scott Sumner's use of it in thinking about the economic crisis. I replied that though it was just an accounting identity, it still shed some light on the economic crisis in its expanded form. Now he is questioning its use as a way to measure velocity. He correctly notes that velocity is nothing more than a residual from this accounting identity, whose value can change based on what measure of the money supply one uses (i.e. V =[PY]/M). He further questions its usefulness by noting in several figures that M1's growth rates seem to be almost perfectly offset by changes in velocity's growth rate. Here is a figure that reproduces Hamilton's M1 graphs for the 1980-2010 period. (Click on figure to enlarge.)

Yes, it is rather striking in this figure that the growth rate of M1 and M1 velocity tend to move in almost perfectly opposite directions. But why should the growth rates of M1 and M1 velocity necessarily move in opposite directions? Hamilton's critique, as I understand it, is that they should move inversely because velocity is simply a residual in the equation of exchange. But this understanding hinges on the assumption that nominal GDP growth is relatively stable. But nominal GDP growth has not always been stable. It just so happens, however, that most of the time in Hamiltion's 1980-2010 figures cover the "Great Moderation", the period when the Fed did a relatively good job of stabilizing nominal spending. One would therefore expect the changes in the money supply to largely offset changes in velocity during this time. The Fed was doing its job. The near symmetry in the figure is a testament to its success.

Now if one looks outside the 1980-2010 period this symmetry is harder to find. Here is the 1960-1979 period with the same series: (Click on figure to enlarge.)

The lack of symmetry here is not particularly surprising. The Fed's performance in stabilizing the growth of nominal spending was abysmal during this time, as shown by Josh Hendrickson. Along these same lines, there are points in the 1980-2010 figure where the symmetry is missing. They all occur during recessions. These are cases where the Fed failed to adequately stabilize NGDP.

I find these figures, motivated by the equation of exchange, insightful. They show there is merit in using the equation of exchange. Moreover, if one looks to the expanded equation of exchange form as done here there is much insight this identity can brig to bear on the economic crisis.

I am late getting to this, but Mark Thoma wants to hear the case for nominal GDP targeting. This approach to monetary policy requires the Fed stabilize the growth path for total current dollar spending. As an advocate of nominal GDP level targeting, I am more than happy to respond to Mark's request. I will focus my response on what I see as its three most appealing aspects: (1) it provides a simple and intuitive approach to monetary policy, (2) it focuses monetary policy on that over which it has meaningful influence, and (3) its simplicity makes it easier to implement than other popular alternatives. Let's consider each point in turn.

(1) It provides a simple and intuitive approach to monetary policy. This first point can be illustrated by considering the following scenario. Imagine the U.S. economy is humming along at its full potential. Suddenly a large negative shock, say a housing bust, hits the economy. This development leads to a decline in expectations of current and future economic activity. As a result, asset prices decline, financial conditions deteriorate, and there is a rush for liquidity. The rise in demand for liquidity means less spending by households and firms and thus, less total current dollar spending in the U.S. economy. Because prices do not adjust instantly, this drop in nominal spending causes a decline in real economic activity too. Thus, even though the primal cause of the decline in the real economy was the housing bust, the proximate cause was the drop in total current dollar spending. The Fed cannot undo the housing bust, but it can prevent the drop in total current dollar spending by providing enough liquidity to offset the spike in liquidity demand. If nominal spending has not been stabilized then the Fed has failed to do this. A nominal GDP target, then, is simply a mandate for the Fed to stabilize total current dollar spending.

Though a simple objective, stabilizing nominal spending is key to macroeconomic stability. The figure below shows that changes in the growth rate of total current dollar spending (i.e. nominal GDP) got transmitted mostly to changes in the growth rate of real economic activity (i.e. real GDP) rather than inflation (i.e. GDP Deflator). This implies that had monetary policy done a better job stabilizing nominal spending then there would have been fewer recessions during this time. (Click on figure to enlarge.)

(2) It focuses monetary policy on that over which it has meaningful influence. There are two types of shocks that buffet the economy: aggregate supply (AS) shocks and aggregate demand (AD) shocks. A nominal GDP targeting rule only responds to AD shocks. It ignores AS shocks while keeping total current dollar spending growing at a stable rate. This is the way it should be. For if monetary policy attempts to offset AS shocks it will tend to increase macroeconomic volatility rather than reduce it. For example, let's say Y2K actually turned out to be hugely disruptive for a prolonged period. This negative AS shock would reduce output and increase prices. A true inflation targeting central bank would have to respond to this negative AS shock by tightening monetary policy, further constricting the economy. A nominal GDP targeting central bank would not face this dilemma. It would simply keep nominal spending stable.

In general, any kind of price stability objective for a central bank is bound to be problematic because price level changes can come from either AD or AS shocks and are hard to discern. For example, was the low U.S. inflation in 2003 the result of a weakened economy (a negative AD shock) or robust productivity gains (a positive AS shock)? It makes much more sense to focus on the underlying economic shocks themselves rather than a symptom of them (i.e. price level changes). Nominal GDP targeting does that by focusing just on AD shocks. This point is graphically illustrated here using the AD-AS model. More discussion on this point can be found here.

(3)Its simplicity makes it easier to implement than other popular alternatives. This is true on many front. First, a nominal GDP target requires only a measure of the current dollar value of the economy. It does not require knowledge of the proper inflation measure, inflation target, output gap measure, the neutral federal fund rate, coefficient weights, and other elusive information that are required for inflation targeting and the Taylor Rule. There will always be debate on which form of the above measures is appropriate. For example, should the Fed go with the CPI or PCE, the headline inflation measure or the core, the CBO's output gap or their own internal estimate, the original Taylor Rule or the Glenn Rudebush version, etc.? A nominal GDP target avoids all of these debates.

Second, nominal GDP targeting would also be easier to implement because it is easy to understand. The public can comprehend the notion of stabilizing total current dollar spending. It is less clear they understand output gaps, core inflation, the neutral federal funds rate, and other esoteric elements now used in monetary policy. The Fed would have a far easier time explaining itself to congress and the public if it followed a nominal GDP target. On the flip side, this increased understanding by the public would make the Fed more accountable for its failures.

Third, a nominal GDP target would take the focus off of inflation and what its appropriate value should be. Thus, if there needed to be some catch-up inflation and nominal spending to get nominal GDP back to its targeted growth path the Fed could do it with less political pressure.

Some folks argue that the nominal GDP targeting is nothing more than just a special case of a Taylor Rule. Maybe so, but they miss the bigger point that nominal GDP targeting is a far easier approach to implement for the reasons laid out above. Moreover, in practice the Fed has deviated from the Taylor Rule and during these times it appears to be more of a pure inflation targeter. Thus, adopting an explicit nominal GDP target would force the Fed to stick to stabilizing nominal spending at all times.

Ultimately, I would like to see the Fed adopt not only a nominal GDP level target, but a forward-looking one that targeted nominal GDP futures market. This is an idea that Scott Sumner and Bill Woolsey have been promoting for some time. See here and here for more on this proposal.

Friday, December 17, 2010

The Weekly Standard has an article by Christopher Caldwell on the challenges facing the Eurozone. It is an interesting article that has as its main thesis the following:

Europe’s countries now face the choice of giving up either their newfangled money or their ancient national sovereignties. It is unclear which they will choose.

This is a conventional view, but is it correct? Are the choices really limited to saving the Euro or preserving national sovereignties? For the long-run the answer is probably yes. It is difficult to make a monetary union work without a political union. For many of the economic shock absorbers needed to make a monetary union work--common treasury, fiscal transfers, labor mobility, price flexibility--either require a political union or would be more effective with one.

In the short-run, though, there is another option: more monetary easing by the ECB. As Ryan Avent explains, further easing by the ECB would cause a real depreciation for the Eurozone periphery vis-a-vis the Eurozone core:

[T]he key to a relatively painless internal revaluation is inflation in tighter markets. And it's here that the European Central Bank could play a particularly useful role. Were the ECB to adopt a looser monetary policy, we would expect inflation to pick up first in the markets with the least excess capacity, and that would obviously mean rising prices for Germany.

Prices, therefore, would increase more in Germany than in the troubled periphery. Good and services from the periphery would then be relatively cheaper. Thus, even though the exchange rate among them would not change, there would be a relative change in their price levels. This would make the Eurozone periphery more externally competitive. The relative price level change would not be a permanent fix to structural problems facing the Eurozone, but it would provide more time to address the problems. Unfortunately, this is not likely to happen. The one thing Germans hate more than Eurozone bailouts is Eurozone inflation.

Tuesday, December 14, 2010

It has been frustrating to watch Fed officials explain QE2. The standard Fed story centers around the QE2 driving down long-term interest rates and stimulating more borrowing. As I have repeatedly noted, this narrow focus on the interest rate channel leaves out many other channels through which monetary stimulus can work. Moreover, it creates the wrong impression that QE2 will only be successful if long-term interest rates are held low. Thus the rising long-term yields are seen by many observers as indicating QE2 is a failure when the opposite is probably true. An anonymous commentator from my previous post eloquently summarizes this confusion coming from the Fed's marketing of QE2:

I agree that rising yields actually indicate that QE2 is working.

But I also have sympathy for all the people who get "confused," because, of course, you have had hoity-toity Fed people themselves saying that one mechanism through which QE will stimulate things is by lowering long-term rates, supporting housing prices, and so on and so forth.

Bottomline, it would sure help if the Fed would clearly and succinctly communicate (a) the mechanisms by which its policies are supposed to work and (b) the sign-posts and markers (e.g., asset price movements) for people to look at to ascertain whether things are going as intended.

Right now we have the utter IRONY of QE2 working exactly as it was intended (thank the lord) and the "experts/pundits" getting downright angry because what they're seeing is not what they expected to see, and, of course, what they expected to see is simply no more and no less than what they were told to expect by the very people who are implementing QE2.

Jeremy Siegel is making the case the case that rising yields indicate the Fed's policy is actually working:

The recent surge in long-term Treasury yields has led many to say that the Fed's second round of quantitative easing is a failure. The critics predict that QE2 may end up hurting rather than helping the economic recovery, as higher rates nip in the bud any rebound in the housing market and dampen capital spending. But the rise in long-term Treasury rates does not signal that the Fed's policy has backfired. It is a sign that the Fed's policy is succeeding.

Long-term Treasury rates are influenced positively by economic growth—which encourages consumers to borrow in anticipation of higher incomes and causes firms to seek funds to expand capacity—and by inflationary expectations. Long-term Treasury rates are affected negatively by risk aversion: Seeking a safe haven, investors pile into Treasury bonds, running up their prices and lowering their yields.

The Fed's QE2 program has raised expectations of growth and inflation, sending long-term Treasury rates up. It has also lowered risk aversion, which implies rising long-term rates. The evidence for a decline in risk aversion among investors is the shrinkage in the spreads between Treasury and other fixed-income securities, the strong performance of the stock market, and the decline in VIX, the indicator of future stock-market volatility. This means that expectations of accelerating economic growth—and a reduction in the fear of a double-dip recession—are the driving forces behind the rise in rates.

More and more observers are picking up on this notion that rising yields may be reflecting an improving economic outlook. As I have noted before, this is a welcome reprieve from the common but wrong view that QE2's success is dependent on the Fed maintaining low long-term interest rates. The correct story goes something like this: higher expected inflation from QE2 should increase expected nominal spending and in turn raise expected real economic growth (given sticky prices and excess capacity).

Here is the latest figure on the 10-year expected inflation (red line) and the 10-year real yield (blue line) from the TIPs market. It continues to show an upward march for real yields.

Update: Underscoring the view that rising yields indicate an improved economic outlook, Catherine Rampell notes three good economic reports came out today (retail sales, small business optimism index, and ppi) and that economic forecasts are being revised up.

What makes a recession a recession, and something more than a bad harvest, or a re-calculation, is that most goods, and most labour, gets harder to sell and easier to buy. And I really want to call that an excess demand for money. Because it is money we are selling stuff for, and it is money we are buying stuff with. And if I've also got a theory as well, which says that an excess demand for money will cause a drop in output and employment, and an excess supply of goods and labour, that's just icing on the cake.

Arnold Kling also had a recent rant over National Review's web page. Just imagine, then, how thrilled he would be to read an online National Review article that supported Nicks' claim that there was a excess money demand problem behind the recent U.S. recession.

Recall that the recovery view begins with notion that a successful QE2 will first raise inflation expectations. The increase in inflation expectations, however, also implies higher expected nominal spending (i.e. higher future nominal spending means higher future inflation). Higher expected nominal spending in an economy with sticky prices and excess capacity should in turn lead to increases in expected real economic growth. Finally, this higher expected real economic growth should increase current real long-term yields. Given the fisher equation, this understanding implies that the rising long-term nominal yields are occurring because of both higher expected inflation and higher real yields.

Though it too soon to know for sure, the data seem to support the recovery interpretation of the rising nominal yields. Below is a figure showing the 10-year expected inflation rate and the 10-year real interest rate from the TIPs market. This figure shows that inflation expectations pick up first and eventually the real interest rate does too: (Click on figure to enlarge.)

If this understanding is correct, then QE2 seems to be doing some good.

Update: Ryan Avent is now fully on board with the recovery view of rising yields:

BUTTONWOOD continues to be sceptical of the Fed's new security purchases. And, you won't be surprised to hear, I continue to think his fears are somewhat misplaced. He writes, for instance:

It is possible that the Fed's actions have actually been counter-productive, since 10-year bond yields are actually higher than they were when the second round of QE was announced. In part, this may be a case of "buy on the rumour, sell on the news". But the 30 basis point rise in bond yields over the last two days has revealed signs of investor cynicism.

Reduced bond yields are not the Fed's goal. The Fed's goal is to facilitate recovery, so as to move inflation and unemployment closer to the central bank's target levels. Beginning in late August, the Fed signalled its intent to do more to achieve its goal through additional purchases of Treasury securities. And indeed, the Fed's messaging was successful; Treasury yields were lower in early October than they were in late August. But lower yields were the means, not the end. The promise of more Fed action boosted markets and expectations, and before long actual economic data was following suit. But of course, we'd expect an improving outlook for the American economy to lift American government bond yields. Yields were low, aside from Fed activity, because investors were uninterested in putting their money in private projects. That's no longer the case; with rising growth expectations comes rising interest in private investment, which makes for falling bond prices and rising yields. Yields are rising because QE2 has been successful.

Tuesday, December 7, 2010

One of the events I enjoy attending here at Texas State University is the semester-end presentation by our student managed investment fund (SMIF). This fund consist of a group of select undergraduate students who manage a small portion of the endowment belonging to the McCoy College of Business at Texas State University. SMIF started in 2006 with $100,000 dollars. Since then, the students have performed as well and is some cases better than the professionals who managed the rest of the endowment. As a result, they are now managing $250,000 and are slated to get $300,000 in Fall 2011. Students in SMIF are assigned to be sector-specific analysts and a few among them get put on the investment committee that makes the final investment decisions. Yes, students do get course credit for their work in SMIF, but more than that they get real investing experience. Very few universities offer such an opportunity to undergraduates. Programs like these make me proud to be a part of Texas State University.

Tonight is the semester-end presentation and for the first time it will be streamed on the internet. Click here if you are interested in watching the students explain their investment choices over this semester. It will take place at 5:30 pm CST.

Randall W. Forsyth dreams he is doing the 60 Minutes interview with Ben Bernanke and comes up with this exchange:

Bernanke: "What we're doing is lowering interest rates by buying Treasury securities. And by lowering interest rates, we hope to stimulate the economy to grow faster,"

Forsyth: "So, why are interest rates higher now after QE2? The key 10-year Treasury note yield is up to nearly 3% from 2.50% just after the Federal Open Market Committee announced the policy change in early November. Mortgage interest rates have climbed to three-month highs and applications fell the most this year in the latest week. So, what's the problem?

Part of the problem is Bernanke and the Fed itself. They should not be creating the perception that a successful QE2 is one that will keep long-term interest low for a sustained period. As I have noted several times now, this is terribly wrong. If QE2 is successful, then we would expect treasury yields to rise! A successful QE will first raise inflation expectations. This alone will put upward pressure on nominal yields. However, expectations of higher inflation are in effect expectations of higher nominal spending. And higher expected nominal spending in an economy with sticky prices and excess capacity will lead to increases in expected real economic growth. The expected real economic growth should in turn increase the real yields. It is that simple. Randall W. Forsyth, therefore, is asking the wrong question. What he should be asking is why inflation expectations have not gone up anymore. If anything, QE2 is much ado about nothing.

What if the PIGS had never adopted the Euro? How would they now be handling the current economic Eurozone crisis? Would there even be a Eurozone crisis? These are difficult questions to answer, but Poland provides something of a natural experiment in that it too is a periphery economy on the Eurozone but has its own currency. So what does this natural experiment show? From the New York Times we learn the following (hat tip Paul Krugman):

The floating zloty, which has fallen about 18 percent against the euro since early 2009, acted as a pressure release valve, helping to keep Polish products competitive on world markets and insulating Poland from the effects of the sovereign debt crisis.

Poland has proved itself to be Europe’s most dogged economy during the last two years. It was the only member of the European Union to avoid recession, soldiering on even after a plane crash in April killed much of the political elite, including the president and the central bank governor. No banks needed to be rescued.

Note that Poland had its own housing boom and the related fallout. Poland, however, pushed hard on expansionary monetary policy in 2009 and secured a confidence-building credit line from the IMF. It also has a smaller banking sector which makes it less susceptible to the problems in Ireland. Still, were it using the Euro and forced to undertake internal price deflation rather than one external price adjustment the outcome most likely would have been far different. Here is the IMF's most recent assessment of the Poland. They too praise Poland's expansionary monetary policy.

Monday, December 6, 2010

So we learn from the 60 minutes interview with Ben Bernanke that if necessary there will be a QE3:

Scott Pelley: Do you anticipate a scenario in which you would commit to more than 600 billion?

Ben Bernanke: Oh, it’s certainly possible. And again, it depends on the efficacy of the program. It depends, on inflation. And finally it depends on how the economy looks.

This ad-hoc approach is exactly why we need a rules-based approach to QE. If the Fed had adopted an explicit nominal target--preferably a nominal GDP level target--and forcefully committed to maintain it no matter the cost, it is unlikely the Fed would need to keep announcing new rounds of QE. All the market would need to know is that the Fed is serious about hitting its nominal target. The rest would take of itself. The market would do the heavy lifting by automatically increasing nominal expectations to a level consistent with the target.

Instead, we get a piecemeal approach where explicit, large dollar security purchases are announced presumably to impress the market. We now know there are two problems with this approach. First, it invites criticism that may hinder the Fed's ability to carry out QE. Some observers, for example, are fearful that the large expansions of the monetary base under QE will become inflationary. If these observers are influential they can create political pressure for the Fed. If the Fed were instead aiming for an explicit nominal target where the expansion of the monetary base would be endogenously determined, this concern would be muted. For there would be no need to announce large dollar security purchases. And, if the market itself did most of the heavy lifting as noted above, the increase in the monetary base probably would be less than under the current QE program. Second, this approach has not convinced the market that the Fed is serious about raising nominal expectations and thus nominal spending. This can be seen in the implied inflation rate from TIPS.

It is time to adopt an explicit nominal target. I nominate a nominal GDP level target.

This is the second of two posts detailing why the Fed's low interest rate policies in the early-to-mid 2000s was one of the more important contributors to the credit and housing boom. In the first post I discussed how the low federal funds rate acted as a catalyst in bringing together the other contributors--financial innovation, weak governance, misaligned incentives, and globalization--to create the perfect economic storm. Here I want to (1) flesh out why the low federal funds rate mattered from a neutral interest rate perspective and (2) discuss how the Fed's low interest rate policy created a global liquidity glut. (The material in this post is mostly excerpted from a previous one of mine.)

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period. It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative. Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential). There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007). Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa. This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate (click on figure to enlarge):

In short, during the early-to-mid 2000s the real federal funds rate was being pushed to an unusually low level just as the neutral real federal funds rate was rising because of the productivity boom. Thus, monetary policy was highly stimulative.

A natural follow-up question is that if the federal funds rate was below the neutral rate for so long, then why was there strong disinflation during this time? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point. It shows the productivity surges at this time coincided with the two sustained drops in inflation. Demand growth, meanwhile, is solidly recovering (click on figure to enlarge):

(2) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom. The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s. Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

Given these points and those noted in the previous post, I am convinced that the Fed probably was one of the more important contributors to the credit and housing boom. If nothing else, it was the one institution that could have slowed down the housing boom through better oversight of lending practices and less monetary stimulus.

Sunday, December 5, 2010

This is the first of a two-part follow up to my previous post, where I argued that the Fed's low interest rate policy was a key contributor to the credit and housing boom. Here, I want to show why the risk-taking channel of monetary policy is an important part of the story. I will provide a more thorough summary of the Fed's role in the next post.

The risk-taking channel of monetary policy helps us understand how the Fed's low interest rate policy worked to catalyze many of the other factors that contributed to the housing boom. Yes, this was a perfect economic storm of sorts where financial innovation, weak governance, misaligned incentives, and globalization all came together to create the mother of all housing booms. Yet, the role they played was largely dependent on the Fed holding the federal funds rate as low as it did for as long as it did. How you ask? I will outsource to Barry Ritholtz to answer this question:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...

An honest assessment of the crisis’ causation and timeline would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as Triple AAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

It became readily clear to me once I dug into the data, legislative history, market activities, etc, that there was no one single factor that caused the collapse. Rather, an honest reading of events was that there were many, many failures occurring in a very specific order that contributed to what occurred.

Inadequate regulations and “nonfeasance” in enforcing existing regs were, as Chairman Bernanke asserts, a major factor. But in the crisis timeline, the regulatory and supervisory failures came about AFTER the 1% Fed rates had set off a mad scramble for yields. Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates.

Friday, December 3, 2010

Tyler Cowen is wondering whether the Fed's low interest rates in the early-to-mid 2000s really were that important to the credit and housing boom of the early-to-mid 2000s. He is having is doubts after seeing this excerpt from Michael Woodford's JEP article:

It is popular to attribute the credit boom (at least in part) to the Federal Reserve having kept the federal funds rate “too low for too long,” but comparison of the path of the funds rate in Figure 5 with the measures of credit growth in Figure 1A shows that the increase in lending was greatest in 2006 and the first half of 2007, after the federal funds rate had already returned to a level consistent with normal benchmarks. Instead, the fact that spreads were unusually low precisely during the period of strongest growth in lending... indicates that an outward shiftof the supply of intermediation schedule XS was responsible.

A question to Tyler Cowen and Michale Woodford: aren't you just the least bit curious about the chronological ordering of the events in the above paragraph? First, the federal funds rate is held below the neutral interest rate level for an extended period. Second, spreads decline and a credit boom ensues. Hmm? Let see, that sounds a lot like the risk taking channel of monetary policy. Here is how Leonardo Gambacorta of the BIS summarizes this monetary transmission channel:

Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.

In terms of the recent credit boom, this channel says that keeping short-term interest rate inordinately low was key in driving down credit spreads and spurring on the credit boom. In fact, Woodford's colleague at Princeton, Hyun Song Shin, and his coauthor Tobias Adrian have several papers on the risk taking channel. Here is an excerpt from a WSJ article from late last year that discusses how this channel was important to the recent credit boom-bust cycle: (My bold below)

Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. "Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage," says Mr. Adrian. That, in turn, "has real effects on the economy."

For a step-by-step account of how this channel worked during the credit boom see this post by Barry Ritholtz. Finally, let me end with George Selgin who provides an assessment of the above paragraph by Woodford:

Let's see: you have excessively low, even negative, rates for several years, and partly for this reason house prices rise exceedingly rapidly. That rapid appreciation in turn stimulates a greater demand for credit, so rates start to come up. At the peak of the lending boom, rates are at or near their "benchmark" levels again. Therefore low rates couldn't be to blame for the boom.

Wow. Now that I know the facts, I am really sorry to have been one of those naive economists who thought the Fed had something to do with it.

Randal Forsyth sees similarities between the current unfolding of the Eurozone crisis and that of the U.S. financial crisis a few years back:

Just as the problem on this side of the Atlantic supposedly was just subprime mortgages, a tiny sliver of the credit market where their obvious but unique abuses, the problem in Europe was supposed to be just Greece, which accounts for a few percent of the eurozone's output.

Then the Federal Reserve-engineered takeover of Bear Stearns by JP Morgan Chase (JPM) in March 2008 was thought to be a one-off affair, just as the bailout of Greece last spring was supposed to be. And for a few months, a tenuous stability returned.

In the summer of 2008, the bailout of mortgage giants Fannie Mae and Freddie Mac staved off a full-fledged crisis but failed to inspire confidence. Now, the bailout of Ireland has been ineffective in staving off contagion to even beyond the other PIIGS -- Portugal, Italy and Spain -- closer to the core. Add debt-laden Belgium to this troubled group as the cost of insuring its debt jumped Tuesday to levels paid by Italy earlier in November, 185 basis points ($185,000 annually to insure $10 million of debt for five years.)

The only thing missing in these parallel developments is the equivalent of the Lehman Brothers collapse for the Eurozone. Should such a cataclysmic event occur in the Eurozone it would probably break up the currency union. So what could this event be? Here is what Desmond Lachman has to say:

The more likely trigger for the euro’s eventual unraveling will be in the periphery itself. Already, the Greek, Irish, Portuguese, and Spanish governments have tenuous holds on political power. A deepening in their economic and financial crises could very well result in the ascendancy of more populist governments, which might be less willing to hew to the hair-shirt austerity programs dictated by the IMF or to remain within the euro straitjacket. This is essentially what precipitated the demise of Argentina’s Convertibility Plan in 2001.

Another plausible trigger for the euro’s eventual unraveling could be a heightening of the capital flight already underway in Greece and Ireland. Ample experience in earlier fixed-exchange-rate regimes suggests that capital flight can reach such proportions that countries are left with little alternative but to restructure their debt and exit their fixed-exchange-rate arrangements.

Wednesday, December 1, 2010

Mark Calabria of the Cato Institute provides a very civil critique of my article in the National Review. He raises three key objections to my arguments in the article. I will address each one in turn.

Calabria's first objection:

[Beckworth] argues that spending is far below trend. That is true enough as it goes, but this trend includes a massive housing bubble, where imaginary wealth fueled spending, aided by massive borrowing from abroad. The objective of our economic policies should not be to get back to the top of the previous bubble. It was this desire to replace the lost wealth of the dot-com crash that contributed to the Fed’s juicing of the housing market. All that said, consumption today is higher than at any time during the recent bubble. The primary problem facing our economy is not a lack of demand.

I never argued in the article for a return to a bubble-driven economy, only to a stable total current dollar spending level. Such an objective, which could be achieved via a NGDP level target, does not require a return to debt-fueled consumption and asset bubbles. As I note in the article, all it requires is for creditor households, firms, and banks to simultaneously reduce their demand for money. There is no need for debtors to incur more debt here. Given the excess capacity and sticky prices, the resulting increase in nominal spending by creditors would occur without new asset bubbles emerging. Asset bubbles typically emerge when market interest rates are held below the neutral interest rate level. This happened in the early-to-mid 2000s; it is not happening now. Interest rates are low now, but so is the neutral interest rate given the weakened state of the economy.

Another way of looking at this trend is to remember there are plenty of non-bubble years that follow the trend closely. If it is possible for these periods to exist at trend without bubbles why not now, especially given all the resource slack? Actually, the trend I showed in article understates the extent of the problem. For it is based off of total demand (i.e. total nominal GDP). If one looks to a measure of demand on a per capita basis, then one finds it has not even returned its peak level. For example, below is a figure showing domestic demand per capita: (Click on figure to enlarge.)

I cannot see anything but a demand problem in this figure. Given the Fed has significance influence over nominal spending, the incredibly slow recovery in this figure also indicates monetary policy has been too tight.

Calabria's second objection:

Beckworth believes we have had no inflation. Again like the Fed, he arrives at this conclusion by subtracting out of the inflation numbers all the things that real people spend their money on, such as food and energy. I would not claim we are facing hyper-inflation, but two facts should be borne in mind. First, over time even low levels of inflation erode away wealth; and second, a large surge of inflation is likely to occur quite suddenly, without giving the Fed months or years of warning.

Yes, core inflation ignores volatile real world items, but it is followed closely for a reason: it is a much better indicator of where inflation is going than the headline number. And after averaging around 2.5%, core inflation began a downward slide starting in late 2008 as seen below. This is actually the lowest it has been since the core measure has been recorded:

If that were not troubling enough, market-based measures of expected inflation had been heading down all year up until the Fed started promoting QE2. Had the Fed not done QE2, then inflation expectations at their existing trend would have become deflationary by mid 2011. Now inflation expectations are important because they provide a proxy for expected nominal spending (assuming no big changes in productivity). Thus, the decline in expected inflation was effectively a decline in expected nominal spending. And of course, expectations of future economic activity help shape current economic activity. Thus, by allowing these expectations to deteriorate for so long, the Fed was effectively tightening current monetary policy.

Finally on this second objection, Calabria's concerns about inflation suddenly exploding and catching the Fed by surprise is really not an issue. This was a problem in the past, but not now because we have real-time, market-based measures in the TIPS market.

Calabria's third objection:

[Beckworth] fails to consider that households may not be “hoarding” cash by choice. After all, most of us still have our cash in banks, even if in transaction accounts. The money hasn’t been stuffed under the mattress. In fact, throughout this recession and financial crisis, the amount of insured deposits has been consistently increasing. We are nowhere near a 1930s style disintermediation of the banking sector, which greatly contributed to an actual decline in the money supply during the Great Depression. Most market participants, me included, would be happy to put their money into valuable investments. Yet with interest rates near zero, there’s little incentive not to hold cash balances, as the opportunity costs are nonexistent.

This last paragraph is way off. If Calabria read the article he would know that (1) I said firms, banks, and households had elevated money demand not just households and (2) nowhere did I say that excess money demand means stuffing money under one's mattress. Obviously, firms and banks can't stuff money under their mattresses! Excess money demand is evidenced by the increased holdings of cash and other highly liquid assets held by creditor households, firms, and banks as seen in the graphs at the bottom of this post. Calabria even acknowledges this is happening in the above paragraph when he mentions the growth in deposit-insured accounts, but somehow gets hung up on cash under the mattress. Thekey to excess money demand is not where it is located, but that it is not being spent. (For a fuller treatment of the excess money demand problem see here.) And all the evidence indicates there are still excess money balances not being spent. The fact that Fed has allowed this to occur amounts to an effective tightening of monetary policy.

Finally, the whole point of QE2 is to raise the opportunity cost of holding money! That is what the Fed can do by raising expectations of inflation and future nominal spending. Yes, QE2 could be done in a more rules-based approach. On that point I am sympathetic to John B. Taylor and Rep. Paul Ryan's call for a more systematic approach to monetary policy. I just ask that nominal GDP level targeting be given a hearing as the monetary policy rule for reasons discussed here and here.

Update: Here is a figure of velocity from an earlier post. This figure also points to an ongoing excess money demand problem.

Now that the Eurozone crisis is heating up again, I thought it worthwhile to revisit an earlier post of mine that discussed the key lessons I see from the Eurozone crisis:

(1) The optimal currency area (OCA) criteria should be taken seriously ex-ante. Before any country joins a currency union it should make sure it has met some combination of the OCA criteria. These criteria tells us that members of currency union should (1) share similar business cycles or (2) have in place some combination of economic shock absorbers including flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. In the former case, similar business cycles among the regions mean that a common monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. In the latter case, dissimilar business cycles among the regions make a common monetary policy destabilizing—it will be either too stimulative or too tight—for regions unless they have in place some of the economic shock absorbers. In short, if a region's economy is not in sync with the currency union's business cycle and the above listed shock absorbers are absent then it does not makes sense for a country to be a part of the currency union. Instead, the country should keep its own currency which itself will act as a shock absorber. This understanding can be graphically represented as follows (click to enlarge):

As shown in this recent post of mine and by others, several of the Eurozone countries fell inside the OCA boundary, Greece being one of them. This is not a surprise to most folks including the Euro optimists, but many hoped that these criteria would be met ex-post as the economies integrated. This leads to the second lesson.

(2) Don't hang your hope on becoming a successful currency union by meeting the OCA criteria ex-post. Some observers argued around the time of the Eurozone's inception that looking at the OCA criteria ex-ante was not warranted since the criteria themselves would emerge once a currency union was formed. This "endogenous" view of the OCA gave hope to the Euro optimists and lent support to their cause. Now there is evidence that joining a currency union does stimulate trade as transactions costs are lowered. One study found currency unions more than tripled trade among members. It is apparent now, though, that some of the Eurozone periphery did not integrate enough to justify the cost of being a member in the currency union. It is best not to base the survival of a currency union on hope.

As an aside, it is worth nothing that even if a region does endogenously meet the OCA criteria further problems can arise from being a part of the currency union. The increased trade flows and economic activity within the currency union can over time lead to regional specialization that makes the regions more susceptible to economic shocks. Paul Krugman first made this point in 1998 and the idea has become known as the "Krugman Specialization Hypothesis" (KSH). I think the best example of KSH is the United States. Despite being a currency union for many years, the United States did not become an OCA until the 1930s according to Hugh Rockoff. One reason is because there was so much regional specialization and until the New Deal reforms, many of the economic shock absorbers necessary to offset the lack of regional economic diversification were simply missing. So even if the Eurozone were a functioning OCA there is no guarantee it would stay that way.

(3) Take the real exchange rate seriously. A summary measure of a country's external competitiveness is its real exchange rate. If a country's real exchange rate is appreciating then its goods are becoming more expensive to the rest of the world. And, as a result, it will begin losing foreign earnings and the ability to meet external obligations. In a time of crisis for a country dependent on foreign funding this problem becomes more pronounced. As seen in the next figure, most of the Eurozone periphery has had a real appreciation on average since the inception of the Euro!

Now to understand why the periphery has had the real appreciation, one has to look at the three components of the real exchange rate: domestic prices, foreign prices, and the exchange rate. For Greece the problem was twofold. First, because of wage pressures domestic prices rose, more so than in the core Eurozone countries. Second, given its membership in the Eurozone, Greece had a fixed exchange rate and, thus, no chance for its currency to depreciate. To get out of this bind Greece can either have painful deflation or end its use of the Euro. Given where Greece is now, leaving the Euro may seem like lesser of two evils for Greek leaders. (Just to be clear, a depreciation will not solve Greece structural problems, but it make it easier to address them.) Any country joining a currency union should consider the implications of membership on its real exchange rate.

(4.) The central bank contributes most to macroeconomic stability by stabilizing aggregate demand (i.e. total current euro spending). I have made this point before for the United States, but it applies just as well to the Eurozone. And based on the following figure, the European Central Bank (ECB) has not done a very good stabilizing total current euro spending during this crisis:

As Nick Rowe notes, the sharp decline in the Eurozone's aggregate demand was avoidable had the ECB really tried to stabilize it. Instead, the ECB mistakenly looked to low short-term interest rates as an indicator of loose monetary policy and became convinced it was doing enough. A better indicator of the stance of monetary policy I have discussed before is to look at the growth rate of aggregate demand relative to the policy interest rate. Using this metric, the ECB policy rate should not deviate too far from the aggregate demand growth rate otherwise monetary policy is either too loose (the policy rate is significantly below the total spending growth rate) or too tight (the policy rate is significantly above the total spending growth rate). This next figure shows this measure for the Eurozone:

According to this measure, monetary policy in the Eurozone has been rather tight over the last year. The Eurozone's future would have been more secure had the ECB been more vigilant in stabilizing aggregate demand.

I make the case over at the National Review that conservatives should support QE2. The punchline is that tight monetary policy almost always leads to more government spending and intervention. The best examples of this are the early 1930s and late 2000s. In both cases effectivelytight monetary policy turned what could have been ordinary recessions into great ones. These great recessions, in turn, opened the door for more government involvement in the economy. From this perspective, QE2 is nothing more than a long overdue attempt by the Fed to set monetary policy right and thereby reduce the likelihood of further government intervention in the economy.

I don’t think that we’re hysterically attacking QE2, so much as pointing out that it’s never been done before, that we don’t know whether it will work, and that, if it doesn’t work, we don’t know how it’s going to fail, either.

No, QE2 has been done before and it worked quite well. As I showed in this post and as noted by Paul Kasriel, the original QE started in in late 1933 and was very effective at spurring a robust economic recovery. And contrary to conventional wisdom, the key to making QE work then and now was not the lowering of long-term interest rates. It was about addressing the excessmoneydemand problem and thereby spurring a recovery in nominal spending. Yes, interest rates may initially fall, but if QE2 works according to plan there should ultimately be an increase in yields. In short, QE2's success is notcontingent on a sustained lowering of interest rates.

Monday, November 29, 2010

The debate over what Milton Friedman would say about QE2 can now be closed. Below is a Q&A with Milton Friedman following a speech he delivered in 2000. In this excerpted exchange with David Laidler, we learn that Friedman's prescription for Japan at that time is almost identical to what the Fed is doing now with QE2: (my bold below)

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

So Milton Friedman said in 2000 that the Bank of Japan should do what the Federal Reserve would be doing 10 years later! In fact, if names, dates, and places were changed in the above excerpt one could get a 2010 Ben Bernanke Q&A. Friedman's belief that a zero policy interest rate could be contratctionary and thus required the central bank to buy long-term securities shows that he understood unconventional monetary policy long before it was vogue. He truly was a great economist.

Note, though, that his emphasis is still on expanding the monetary base as much as needed to start and maintain an economic expansion. This implies he saw an excess money demand problem in Japan, just as there is one today in the United States. He understood, though, the need to expand the monetary base through purchases of long-term securities rather than short-term ones. This is because short-term securities are close to a perfect substitute for the monetary base at a zero percent policy rate. Swapping perfect substitutes does not change anything in one's portfolio of assets and therefore has no effect on spending. Thus, Friedman saw the need for purchasing long-term securities, which are not perfect substitutes with the monetary base.

Although Milton Friedman probably would have preferred a rule-based approach to QE2, this excerpt is the smoking gun that ends all debate on whether he would have supported QE2. The case is closed.